Advantages and Disadvantages of Licensing as a Mode of Entry Into Foreign Markets
“Assess the merits and demerits of international licensing as a mode of entry into new markets” Disney does not have to produce t-shirts, USB sticks and even waffles with Mickey Mouse’s happy face on it. Instead, it can license the right to use its famous character to different companies around the globe and enjoy the hefty royalties, which in 2010 totaled 28. 6 billion dollars (Rorie, 2011). Does it then mean that licensing as a mode of entry into foreign markets is the best option available? Not necessarily so.
Given a multitude of foreign market entry methods, all of them being used in practice in some contexts, it is crucial to determine under which circumstances licensing will pay off. The decision factors include the specifics of the foreign market; ownership, location and internalization advantages; resources and capabilities; and the general global strategy of a company. This essay will attempt to analyse what kind of environment would be favourable for the introduction of licensing and use this analysis as a context to assess the pros and cons of this mode of foreign
It is useful to start with the detailed definition of the subject matter. According to Daniels, 2003, “under a licensing agreement, a company (the licensor) grants rights to intangible property to another company (the licensee) to use in a specified geographic area for a specified period in exchange for a fee” (called royalty). The “intangible property” might encompass patents, designs, trademarks, methods and the like; we therefore see that licensing does not refer to actual physical objects or services. Hill, 2009 and Daniels, 2003 suggest a number of situations which might inspire executives to consider licensing.
For example, the company’s new product or process might be potentially profitable, but too limited in scale or in duration to justify establishing production facilities abroad. However, even if the project is very promising, insufficient capital might be the obstacle. Licensing might also be taken into consideration when an asset falls outside the domain of company’s core competence or when a company cannot think of an immediate business application of the asset. An example of this is the case of Bell Laboratories, which invented the transistor circuit but then decided it did not want to produce transistors Hill, 2009). Moreover, licensing might be the smartest idea when speed is crucial and a product needs to be introduced in many markets simultaneously, for example because of competitive pressures. Finally, licensing sometimes might be simply the only viable option. It could be either because of regulations limiting FDI or imposing tariffs, or because of other obstacles: for example, Starbucks’s only way to establish its business inside the hotels abroad is to license its model to the hotel chains. Licensing, when properly applied under the circumstances described above, can deliver a wide array of benefits.
First of all, it is frequently the cheapest option. Not only does the licensor not need to bear the costs comparable to those of FDI, but also all market research, adaptation and set-up costs are usually born by the licensee. Moreover, even though royalties are often based on the actual or projected volumes of sales, the agreement often includes the “front-end” fee, which means that the licensor is guaranteed a certain amount of money. Consequently, licensing is virtually financially risk-free for the licensor (risks other than financial are discussed later in the essay).
Another type of risk which is eliminated thanks to licensing is the political risk: because the economic activity is ultimately performed by a domestic company, the “liability of foreigness” disappears (Griffin, 2007, p. 331). This factor is exceptionally relevant in the most unstable countries, where the changes of laws and authorities are frequent and sudden. It needs to be stressed that a licensing agreement inevitably involves a second party, which results in additional resources and capabilities contributing to the success of the product.
One of the best examples illustrating the above statement is Nintendo’s practice of licensing the right to design and manufacture games for its consoles. This arrangement has several advantages. The most obvious one is the additional stream of revenues resulting from the royalties. Moreover, the more video games are produced, the more attractive is the choice that consumers face, which in turn affects the demand for consoles (Griffin, 2007). This impact can actually be tremendous when creative licensees explore new uses of the console and cater to a wide range of gamers’ tastes.
This business model, in a modified version, was applied more than a decade later by Apple, which allowed developers from around the world to design applications for the iPhone. At the moment, the App Store with its 500,000 useful, funny, innovative or amusing applications (Wehner, 2011) is a major competitive advantage for Apple. Another example illustrating this point is the aforementioned Mickey Mouse-shaped waffle: by unleashing the creative potential of a licensee, Disney can reap rewards from an innovative product it would not come up with by itself.
Even though Disney does not have clothing and toy factories, it can still license its merchandise and capture the maximum of the consumer surplus. Despite the multitude of its benefits, licensing also has a number of serious shortcomings. First of all, it often does not fulfill the major purpose of expansion, namely the maximization of profits. Licensing agreements usually set royalties at 3-5 per cent of the sales revenue (Griffin, 2007), but margins in some industries, notably pharmaceutical or software, can be much higher.
Moreover, when a company licenses a product abroad, it potentially misses lucrative opportunities for economies of scope: clients purchasing the licensed product might be willing to obtain supportive services or supplementary products, but the licensor is not in position to sell those. The second major drawback of licensing is the huge counterparty risk, which is a problem even when the most detailed agreements are used. A licensor selling a brand or a trademark put this asset at risk: when a reputation of a brand is damaged abroad, it will also suffer in the home country.
Licensing also creates considerable dependence of the licensor on the licensee. The example here is the agreement between Laura Ashley and L’Oreal, whereby the right to manufacture and distribute perfume branded “Laura Ashley” was granted to the French cosmetics producer, who downplayed the importance of the development of this product. This dispute resulted in a trial and lost revenue (Griffin, 2007). Another potential problem with the counterparty is that it may become a future competitor for the company.
This is what happened when RCA licensed its TV-making technologies to Sony and Matsushita. The latter two companies soon entered the US market, stealing a significant share from RCA (Hill, 2009). The expertise, know-how and tacit knowledge obtained by using the intangible asset stay with the licensee even after the expiration of the agreement. There is a real risk that when a company later decides to enter a foreign market, it will most likely have to compete with the modified versions of its own products.
The above exemplifies a broader problem: the loss of control by the parent company over its own product. Although a lot can be specified in the agreement, the licensor generally does not have much control over the distribution, marketing, manufacturing and strategy. The efforts of the licensee might be either of poor quality, or simply inconsistent with the standards of the licensor, and this might be harmful to a firm’s competitive advantage.
Another problem with the agreements is that they might sometimes be very difficult to enforce. Ironically, companies which choose licensing as a mode of entry to unstable countries because they want to avoid political risks, often find themselves not being able to enforce the agreements because of the weak judiciary system or non-reliable authorities (Griffin, 2007). In light of the above difficulties, many alterations and alternatives to licensing have been suggested.
For example, the problem of control can be partly solved by franchising, which is actually a sub-category of licensing. According to a typical franchising agreement, not only the intangible property is transferred to the franchisee, but he or she also agrees to abide strict rules of doing business and receives constant assistance which might express itself through marketing or product supply (for example, mozzarella cheese for all Domino’s Pizza outlets is imported from the same supplier in New Zealand).
Franchising is nowadays mostly associated with fast-food chains and although it has proven successful, it still poses some control challenges which are the reason why Starbucks still refuses to adopt it as the main way of expansion. Another problem is that in order to ensure the sufficient quality of service and products, often additional investments are required, like McDonald’s factory of burger buns in the UK (Daniels, 2003); such investments seriously overshadow cost advantages of licensing.
Joint venture combined with licensing is another possible answer to some troubles with the latter, namely the loss of control and very limited participation in profits. A good example of the licensing-joint venture mix used in practice is the one of Fuji and Xerox described in Hill, 2009; in fact, licensing intangible assets to subsidiaries or joint ventures is quite a common practice (Griffin, 2007). However, the counterparty risk, although reduced by close cooperation, is not entirely eliminated.
One way to address this issue is to enter the so-called cross-licensing agreement, whereby the intangible assets are exchanged rather than purchased, which gives way to application of the tit-for-tat strategy in case of non-compliance of one of the parties. This is a popular solution in the fast-changing technology sector. As we see, the merits of licensing roughly equal the demerits in both the number and importance.
However, they matter to a variable extent in certain situations: Disney might easily, successfully and lucratively license its Mickey Mouse design to Topshop, but Coca Cola would probably lose a lot by licensing the secret formula of its syrup to an external producer. Each business situation is different and even if licensing is used as one of the many available options, the agreement still needs to be carefully crafted so that both sides are aware of their duties and rights as well as potential gains.
Although licensing is only viable for companies whose competitive advantage at least partly relies on the intangible assets, these companies should definitely not disregard it as a way to enter a foreign market. (1714 words) Bibliography Daniels, John D. , Radebaugh, Lee H. , Sullivan, Daniel P. , 2003. International business: environments and operations, 10th ed. Upper Saddle River, New Jersey; London: Prentice Hall Griffin, Ricky W. , Pustay, Michael W. International business: a managerial perspective, 5th ed. Upper Saddle River, NJ: Pearson/Prentice Hall Hill, Charles W.
L. , 2009. International business: competing in the global marketplace, 7th ed. New York; London: McGraw-Hill/Irwin Rorie, Matt, 2011. Disney Rakes In $28. 6 Billion In Licensing Sales In 2010. [online] Screened. com, available at http://www. screened. com/news/disney-rakes-in-286-billion-in-licensing-sales-in-2010/2254/ [Accessed 26 November 2011] Wehner, Mike, 2011. Apple approves its 500,000th app, but do you care? [online] Yahoo News, available at http://news. yahoo. com/blogs/technology-blog/apple-approves-500-000th-app-care-160140999. html [Accessed 26 November 2011]